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Are There Reasons to Worry About Gold?

Demand for gold will remain strong in the years to come given the demand for jewelry, bars and coins as well as its safe-haven appeal. Yet, the gold mining industry has a number of lurking headwinds. Below, we have discussed some of the key challenges and what investors in the sector can look forward to in the coming months and years.

Production to Flatten on Lack of New Projects

Mine production in 2015 saw its first quarterly decline and its slowest annual growth rate since 2008. While output is slowing down from older mines, particularly in South Africa and the U.S., the incremental impact on production from new mines coming on stream is gradually on the ebb. Previously, incremental production from newer mines led to continued growth in overall gold production. However, newer mines are now at or near their full potential, leading to a slowing down in the growth rates. This has made further production gains increasingly difficult.

After a period of implementing cuts to spending on capital and administration, much of the recent cost reduction has come from lower oil prices and favourable exchange rate moves. Reduced spending on exploration and development has already taken its toll on the production pipeline and will further squeeze production over the coming quarters.

Some gold companies, including Barrick Gold Corporation (ABX - Free Report) , Goldcorp, Inc. (GG - Free Report) and Newmont Mining Corporation (NEM - Free Report) , are currently high-grading at certain mines. The high-grade portion of a mine is mined first as this increases the grade of the mined ore and lowers cost per unit. However, it has its pitfalls as it depletes reserves very quickly, thus affecting long-term supply.

Gold miners, grappling with low gold prices and cost pressure, have not been in a position to invest in new projects in recent years. Companies including AngloGold Ashanti Ltd (AU - Free Report) and Agnico Eagle Mines Limited (AEM - Free Report) have slashed capital and exploration spending. Given the lack of new projects, mine production will eventually reach a plateau in the next couple of years.

Restricted Margins

The price decline in past years added to the woes of an industry that was already fighting rising costs, labor issues, strikes, delays and/or the cancellation of projects. As costs are difficult to curtain beyond a point, miners will only profit if gold prices rise in response to demand and other macroeconomic factors. Production cutbacks and mine closures would spell more financial pain for producers and investors, who have watched gold mining stocks slump. In case market fears are allayed and gold prices fall again, the industry would see a rise in the number of producers reducing output or even shutting down operations.

A Struggling China

China's stock market has been shaken by the slowdown in the country's economy. China's economy grew at an annual rate of 6.7% in the first quarter, the slowest quarterly growth in in seven years. The International Monetary Fund (IMF) projects 6.5% growth in China in 2016. The international organization cut its 2016 world growth outlook to 3.2% from its earlier estimate of 3.4% as China’s slowdown and weak commodity prices are taking a deeper toll on emerging markets than expected.

Gold Substitutes in Technology

Demand for gold in technological applications is affected by sluggish economic conditions in key markets and substitutes found for the metal. Despite inferior durability, copper and palladium-coated copper have made vast inroads into the share of gold in the bonding wire sector. The decade-long decline in the dental sector shows no sign of abatement as gold continues to lose ground to ceramic alternatives, which have improved steadily in quality, strength and durability.

Low Recycling Levels

Recycling fell for the sixth consecutive year in 2015. Supply from this source was down almost 40% from the peak attained in 2009. Recycling activity will remain low and might deteriorate further given that a large portion of near-market supply has been flushed out in recent years. Less distress selling may further suppress recycling volumes. Many collectors are struggling to source feed stock.

U.S. Dollar vs Gold Prices

There is an inverse relationship between the trade-weighted U.S. dollar and the price of gold. If the dollar gains strength against major currencies on the back of positive macroeconomic data, like an improving job market and growing industrial activity, it will again put gold prices under pressure.

Inherent Risks

Gold exploration and mining are time consuming and expensive tasks. Given its scarcity and remote location of deposits, exploration for new gold deposits is difficult. Once an economically viable deposit is identified, bringing a mine on line can take a decade or more, and it requires substantial capital investment.

Moreover, the mining industry is subject to several risks such as political conflicts, environmental hazards, industrial accidents, unexpected geological conditions, labor force disruptions, unavailability of materials and equipment, weather conditions, pit wall failures, rock bursts, cave-ins, flooding, seismic activity and water conditions. However, once a mine is successfully developed, its returns can be enormously high. This will more than offset the risks inherent in development and the capital invested for the project.

Bottom Line

Dwindling production, lack of new projects and decline in recycling activity and the constant threat of a stronger greenback are some of the sector’s worst detractors. But what about investing in the space right now; are there opportunities for short-term investors overriding the headwinds?

Check out our latest Gold Mining Outlook for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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